Do You Know How Your Investment Income is Taxed?

As we approach tax-filing time, you'll want to be thoroughly familiar with what you've earned this year - and how it's going to be taxed. Of course, you probably already know your tax bracket - but not all your income is taxed at that rate. To really understand your tax situation, you also need to know how your investments will be taxed.

So, in case you need a quick review, here's the tax situation on three of the main sources of investment income:

• Dividends - Dividends used to be taxed at your ordinary income tax rate. But, after the passage of new tax laws last year, qualified dividends are now taxed at a maximum of 15 percent. (The law expires on Dec. 31, 2008; after that, dividends are again scheduled to be taxed at your personal tax rate.)
  
  Most domestic stock dividends qualify for the new rate - unless you keep these stocks in a tax-deferred account, such as a traditional IRA. In that case, your dividends will be taxed at your ordinary income tax rate when you eventually take withdrawals, usually during retirement. Look for those stocks that have a long history of paying - and raising - dividends. Keep in mind, however, that even these stocks may not pay dividends and are subject to market risks including the potential loss of principal invested.
  
  
• Capital gains - Long-term capital gains (on stocks held for at least a year) are now also taxed at a maximum of 15 percent. (These capital gains are taxed at 5 percent for taxpayers in the 10 percent or 15 percent brackets. Some exceptions may apply. Effective for sales of assets after May 5, 2003 and expires Dec. 31, 2008.) But if you incur short-term gains, you'll still pay taxes at your individual tax rate.
  
  Clearly, you're far better off, from a tax standpoint, by holding your stocks for at least a year. And even from a strictly investment point of view, it's usually a good idea to hold high-quality stocks for the long term. We believe that over the long term, good companies, with strong management and competitive products, usually will reward investors. By contrast, if you buy and sell stocks every few months, you won't just incur heavy short-term capital gains taxes and commissions - you also can derail steady progress toward your long-term goals.
  
  
• Interest - The interest you earn on certificates of deposit (CDs) and most bonds still counts as ordinary income. If you think you're paying too much in taxes on these types of investments, you might want to look for alternatives, or at least variations. For example, if you're in one of the higher tax brackets, you may be able to benefit from investing in municipal bonds, which typically offer interest payments free from federal income tax. In fact, depending on where you live, your municipal bonds could be exempt from state and local income taxes. Be aware, though, that some municipal bonds may subject you to the alternative minimum tax (AMT).

Review your portfolio
By reviewing your investment portfolio carefully, perhaps in conjunction with your investment and tax advisors, you'll get a clear sense of what sort of taxes you may be facing when it's time to file. And you may also find opportunities to brighten your tax outlook when next year rolls around.